19.1 Payoff Tables and Decision Trees

Problems for Section 19.4
Summary 25
The risk seeker’s curve represents the utility of someone who enjoys taking risks. The
utility is greater for large dollar amounts. This curve represents an individual who is interested
only in “striking it rich” and is willing to take large risks for the opportunity of making
large profits.
The risk-neutral curve represents the expected monetary value approach. Each additional
dollar of profit has the same value as the previous dollar.
After a utility curve is developed in a specific situation, you convert the dollar amounts to
utilities. Then you compute the utility of each alternative course of action and apply the decision
criteria of expected utility value, expected opportunity loss, and return-to-risk ratio to
make a decision.
APPLYING THE CONCEPTS
19.23 Do you consider yourself a risk seeker, a risk
averter, or a risk-neutral person? Explain.
THINK ABOUT THIS Risky Business
When you make investment decisions, you need
to think about your own personal tolerance for
risk. When given the chance to make large sums
of money, some people can shrug off a 20%
loss, while others feel ruined when they lose
even a small amount such as $20. What about
you? Are you willing to risk losing a lot of money
for a chance to strike it rich? Or are you more
comfortable with a less risky scenario, even
though your chance to strike it rich will be
smaller?
How can you identify stocks, mutual funds,
or other types of investments that fit your own
personal tolerance for risk? One way to begin is
to examine the standard deviation of the investments
you are considering during recent periods
of time. You will also want to assess your own
willingness to tolerate different losses. What
would you do if you lost 10%, 30%, 50%, or 90%
of your investment? Would you sell? Would you
buy more in the hope that the investment would
go back up? Also, think about what you would do
19.24 Refer to Problems 19.3–19.5 and 19.12–19.14,
respectively. In which problems do you think the expected
monetary value (risk-neutral) criterion is inappropriate?
Why?
if your investment went up 10%, 50%, 100%, or
200%. Would you sell the entire investment? Part
of the investment? Or would you buy more? You
might want to think about the volatility of your
investments—that is, any patterns of extreme
increases and decreases in the value over short
periods of time—that can add to the risk.
Everyone is different, but knowing how you
would answer these questions before you are
faced with making a decision will help you make
better investment decisions.
USING STATISTICS @ The Reliable Fund Revisited
SUMMARY
In this chapter, you learned how to develop payoff tables and
decision trees, to use various criteria to choose between
In the Using Statistics scenario, you learned how the manager of The
Reliable Fund could use various decision-making criteria to decide
whether to purchase stock A or stock B. You also saw how sample
information could be used to revise probabilities and possibly change
the decision reached. You found that stock B had a higher expected monetary
value, a lower expected opportunity loss, but a lower return-to-risk ratio.
alternative courses of action, and to revise probabilities,
using Bayes’ theorem, in light of sample information.